Why the pound isn’t rising even though interest rates are

Intuitively, the prospect of higher interest rates should bolster a domestic currency. But there are other factors at play - and where rates will go next is no longer clear cut, either.

Take the UK: on the one hand, falling energy prices and slowing inflation could mean that peak interest rates are already in sight. In last month’s monetary policy committee (MPC) meeting, the Bank of England (BoE) acknowledged that further rate hikes would “depend on evidence of more persistent” inflationary pressures. But since then economic growth has proved more resilient than expected – will this encourage the MPC to keep rates higher for longer? 

It’s not only UK interest rates that matter: exchange rates are, after all, the price of one currency in terms of another. Marc Cogliatti, head of global capital markets at Validus Risk Management, notes that sterling has been under pressure against the dollar during the past few weeks, “not because of expectations of lower UK rates, but due to a shift higher in US rates”. Strong US economic data over the past month has led investors to factor in a higher peak Federal Reserve funds rate – in short, more hikes are now more likely.

In the wake of the European Central Bank’s (ECB) recent hawkish comments, Consensus Economics forecasts suggest that eurozone interest rates will rise to 3.75 per cent by June – a record high for the bloc. If the ECB stays hawkish for longer than the BoE, the pound could slip further against the euro this year. 

Yet interest rates are not the only driver of FX movements. Progress on the Northern Ireland protocol could, in theory, be good news for sterling – but analysts are not all convinced. ING global head of markets, Chris Turner, thinks that Conservative party eurosceptics could thwart progress, and that prime minister Rishi Sunak will prove reluctant to rely on Labour votes to win progress in parliament.

But over the longer term, Brexit-related policy changes could influence the performance of the pound. Bank of America FX strategist Kamal Sharma argues that, looking towards the next general election, it is possible that a new government could form “with more sympathetic leanings towards the EU”. He adds that this could be “material for the hopes of a sustained sterling recovery”.

Sharma also thinks that while sterling used to be “the consummate rates play”, business cycle and interest rate moves are no longer the major driver of sentiment. He argues that the value of the pound is now more responsive to medium-term structural factors, noting that personal consumption is heavily correlated to the performance of the pound. Sharma expects the drag on household income to set the tone for the currency in the coming year, and warns that “current trends do not look promising”. 

A darkening UK economic outlook could also sour risk sentiment, boosting the dollar through a flight-to-safety process. According to Capital Economics forecasts, we will see a real gross domestic product (GDP) contraction of -1.3 per cent in the UK in this year, compared with 0.4 per cent growth in the US. This could see the pound fall to around $1.12 against the dollar by the middle of the year. 

A fall in the exchange rate might be good news for UK investors – in the short term at least. A weak pound increases the value of foreign earnings when converted back into sterling, a significant boost when you consider that only 21 per cent of FTSE 100 revenues come from the UK. Did this effect help to propel the index to record highs last month? 

Laith Khalaf, head of investment analysis at AJ Bell, notes that the last calendar year in which the FTSE 100 outperformed the S&P 500 was in 2016, when the pound plummeted following the EU referendum (see chart). But of course it is not all positive. He warns that “while a weak pound may be a shot in the arm for the UK stock market, it is also a vote of no confidence in the UK economy”.